By Samiran Chakraborty and Baqar Zaidi
The “Goldilocks” story of the Indian economy has hit a small roadblock from an unexpected corner. Rising vegetable prices, particularly that of tomatoes, are likely to push the hitherto retreating headline inflation above the Reserve Bank of India’s (RBI’s) tolerance limit of 6% again, for the month of July, as the Monetary Policy Committee (MPC) assembles for its August meeting. But, before we analyse this dilemma in front of the MPC and its options to deal with the same, let us lay down the broader macro backdrop, starting with the global economy.
Repeated rate hikes by central banks, especially in the developed world, are not hurting global growth as much as it was feared earlier. This resilience implies that global GDP growth could be near 2.5% in 2023, and recession scenarios for the developed countries are being pushed back to 2024 now. To make matters better, the inflation momentum is easing in most of the world as the receding commodity prices create a disinflationary impulse. Though headline inflation remains quite off from the targets, central banks are possibly heaving a sigh of relief as they can sense the nearing peak of the hiking cycle. The RBI MPC is likely to draw three inferences from these global developments—first, the challenges to India’s GDP growth from global growth headwinds might be relatively lower now; second, global disinflation is likely to have a positive spillover on India’s domestic inflation; and third, the interest rate differential with the rest of the world might not compress too much from the current levels. All these factors would have otherwise provided the RBI MPC relative comfort about a favourable domestic growth – inflation balance compared to even the June policy meeting.
High-frequency indicators suggest that India’s growth is also showing significant resilience. GDP growth for Q1FY24 could be higher than 8%, aided by a favourable base and persistent momentum. Although consensus forecasts have been a tad lower, the RBI probably will maintain its 6.5% GDP growth forecast for FY24. At the moment, it is quite clear that there are not too many visible cyclical growth risks to warrant a dovishness in the monetary policy to propel growth. Growth risks could emerge in the latter part of the year, but it is too early to build them into policy action.
The dilemma is with respect to the inflation trajectory. After staying within the RBI comfort zone of below 6% for four consecutive months, the headline CPI is likely to cross the critical 6% threshold again for the July print. We estimate the July CPI to be 6.8%, with 150 bps of the 200 bps increase for the month contributed by tomato prices alone. Historically, tomato prices have been mean-reverting—fresh supply of this short-duration crop helps, and there could even be some demand-drop at these elevated prices. While the tomato price normalisation should start soon, since prices have reached unprecedented levels, full reversion might have to wait for the winter crop.
Also, there could be risk of a wider spread to other food prices. It is ironical that while, during the June policy meeting, the concern was on possible El Nino developments leading to drought-like conditions, the August MPC meeting might have to consider the probable impact of floods in certain parts of the country! The lopsided spatial distribution of rainfall might not let the MPC feel comfortable about the progress of monsoon despite the average remaining close to normal for yet another year. Global prices of items like rice, palm oil, etc, are on the rise and could prompt the MPC to be cautious on its inflation outlook too. The uncertainty on the food-prices front could overshadow the positive development on the core-inflation front where the declining momentum is quite encouraging.
The effects of the past rate hikes are still working through the system and the MPC need not react to this bout of food-price-driven inflation. Even the stance of “withdrawal of accommodation” can be maintained as durable system liquidity continues to be more than Rs 3.5 trillion and financial conditions in general remain quite easy. Market consensus is veering towards this sort of an outcome and the only debatable aspect from the policy would be the tenor of the statement which can give us some guidance about the future policy rate path.
The policy could be interpreted as having a “dovish” bias if the MPC clearly states that they are going to “look through” the short term vegetable-price-driven inflation spike and focus more on the durable decline in core inflation. Another way of expressing this could be through their inflation forecasts. The RBI will probably have no choice, but to raise their average FY24 inflation forecast of 5.1% by 20-30bps. However, if they continue to show that the 9 -12 month ahead inflation forecast is around 5%, then a 150-bps real policy rate can be considered appropriate and the markets would not fret about any surprise rate hikes.
On the other hand, it is quite likely that the RBI would re-emphasise the sanctity of the 4% CPI target and repeat that staying within the range is not good enough. This per se might not be treated as a “hawkish” signal.
If the MPC goes beyond and signals that repeated supply-side shocks also warrant monetary policy action at some point of time to align the headline CPI to its medium-term target, then it can be construed as “hawkish”. Another way of expressing that could be to explicitly state that they have not reached the peak of the rate cycle as inflation expectations have not yet been firmly anchored.
The August MPC is going to be all about these nuanced readings of the statement as the rates and stance are likely to be kept unchanged with a bout of uncertainty creeping in on inflation. In our base case, we expect an open-ended tightrope walk from MPC, highlighting both the mean-reversion tendency of vegetable prices and the necessity to align headline CPI towards the 4% medium-term target.
Writers are respectively, MD and chief economist (India), and economist (India), Citi Research,
Citigroup Global Markets India